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Fraud on the Market 2: Finding the Middle Ground

Those who read my first fraud-on-the-market article may have noticed that I only discussed the two options for the Supreme Court to take regarding the use of the fraud-on-the-market theory as a way to show commonality and predominance at class certification. Those two options were keep it or toss it. There may be a middle ground, however. While the two sides in the case have remained on opposite ends of the dichotomy, some third parties have weighed in suggesting a option that would act as a compromise between the two extremes.

If you listened to the oral arguments, you will have noticed that the Justices frequently questioned the attorneys about the position taken by the law professors in one of the amicus briefs. This brief is a rehash of a brief submitted to the court by the same amici plus another professor from Yale in the first examination of this case by the Supreme Court. This position finds a compromise between the two extremes of eliminating fraud-on-the-market as a method to certify the class and retaining the status quo.

The first claim that the amici make is that efficiency of the market is not necessary to show that there has been a fraud on the market. They argue that the courts do not need to find that the market is completely efficient but only efficient enough that it incorporated the allegedly fraudulent information. The question shouldn’t be whether the market was in such a state that it could have been fooled by any fraud, which is what the case would be given a truly efficient market. Instead they argue that the issue that should be addressed in each case is whether it was fooled by that specific alleged fraud.

They conclude that the current operation of the presumption created in these cases is both over and under-inclusive as to potentially valid claims. The bigger companies that trade on the more well known exchanges can be challenged by less valid claims where, for one or many reasons, the market did not rely on or incorporate the information because the market is presumed efficient. As was mentioned in my first article on this, while defendants technically have the opportunity to rebut the presumption that is created, as a practical matter, the cases settle before they reach that stage. It is also stated that smaller companies can avoid meritorious claims because the market that they trade on is seen as less than efficient.

“Basic’s focus on the overall efficiency of a market, rather than the effect of the specific misstatement, needlessly limits investors’ ability to employ the class-action mechanism with respect to less efficient markets, even when the market price reflects the alleged misstatements.”Law Professor’s brief at 10.

The amici further argue that, since Basic v. Levinson, there has been research indicating that the established markets were not as efficient as once thought. Not only is the finding of an efficient market not necessary to show a that a fraud was relied on by the market but it should be harder than it currently is to get the court to establish that the market was efficient.

So the amici then want the fraud-on-the-market question to be determined by a finding that the market relied on information instead of a broader claim that the market is efficient. What they suggest is that courts examine the movement of the market at the time of the release of the information in order to determine whether the plaintiffs relied on that information when purchasing. They suggest that this be done through an event study.

The event study is a regression analysis that is done to determine if an event had an effect on stock price. The brief argues that these studies are already in use to show market efficiency and thus could be taken a little further to show reliance of the market on the information. They suggest that the information be used to study the movement of the stock at the time the misleading information was provided or, in the case of the omission of material information, the time that that information was made available.

The event study brings up questions about proving damages and loss causation at the class certification stage, a question that has been given a lot of attention by the Supreme Court recently. The first case to touch on similar issues was the first time that Halliburton went to the Supreme Court. In this iteration, the issue was whether the plaintiffs were required to prove loss causation at the class certification stage. Loss causation is the causal connection between the misrepresentation and the loss suffered by the purchasers of the Halliburton stock (See Halliburton Opinion Pg. 2). The court decided unanimously to state that loss causation was not required in order for plaintiffs to certify a class. The Court did note that Halliburton was arguing that what was referred to was not “loss causation” but “price impact,” the effect of a misrepresentation on the stock price. Halliburton argued that if the misrepresentation did not effect the price of the stock, then the plaintiffs cannot be said to have relied on them under the fraud-on-the-market theory. Chief Justice Roberts, writing for the court, narrowly tailored the opinion to make no judgement about Halliburton’s “price impact” argument but instead dismissed it as an incorrect interpretation of the opinion of the appellate court.

The second case that may be indicative of the Court’s forthcoming decision is Comcast Corp. v. Behrend. Here, the Court was considering similar issues of Rule 23(b) of the Federal Rules of Civil Procedure but in an antitrust context. The Court noted that the appellate court did not require an exact damage calculation but an indication from the plaintiffs that they would be able to tie the damages to the antitrust impact. Antitrust impact is that theory of a potential cause for anti-competitive price distortions. The problem was, however, that the study included the effect of theories of antitrust impact that were not accepted by the lower court. This, the Supreme Court ruled, rendered the study to be ineffective to show the connection between damages and the antitrust impact. The Court did, however, indicate that the study might have been sound had all four of the proposed antitrust impacts been accepted by the lower court.

The Court had the opportunity to rule on the requirement of event studies in the first Halliburton decision, but as the Supreme Court is want to do, it refrained once it found the ability to decide the case on other grounds. Comcast has potentially changed the analysis in the interim, however. As Daniel J. Dunne, David M. Goldstein and Christin J. Hill argue, Comcast increases the scrutiny that is placed on plaintiff’s expert claims regarding the connection of the fraud to the market price. This increased scrutiny could call for the Court to look for a way to constrict the ruling in the first Halliburton to only apply to loss causation and not to apply to price impact. This could allow for the Court to approve of the requirement to provide an event study to connect the misrepresentation to the stock price to show that the misrepresentation is a potential cause of a price distortion. The Court would then be within its precedent to approve the use of event studies to establish a fraud on the market and thus show commonality and predominance.

Just because the Court is not restrained from allowing event studies doesn’t mean that it will. Having the third option of the use of event studies as a modification to the fraud-on-the-market theory could also syphon only a vote or two from the other positions and thus produce a trichotomous decision. What the court will actually decide, remains to be seen.

If the Court does go with the event study then, it could be two-sided. While it will likely allow for a stronger defense with regard to securities claims against larger companies, as the brief suggests, this could partially be offset by the availability of cases against smaller companies trading on less liquid markets. It will also add expense to the class certification stage of the case. This cost to plaintiffs may need to be covered by a higher settlement number. If they do go this route, it will be interesting to see what effect it has on the class action securities litigation landscape, and whether it spills into other class action areas.